Abstract:
High marginal taxes discourage work effort, but reduce unemployment if labor markets fail to clear. I study the implications of this employment-enhancing effect of tax progressivity for the optimal design of redistributive taxes. To do so, I analyze a model with search frictions in which firms compete for workers with different abilities. High marginal taxes reduce work effort, but – by lowering posted wages – increase employment. High average taxes, on the other hand, raise posted wages and thereby reduce employment. Provided the government cannot tax match-specific output, these (un)employment responses call for intuitive adjustments of standard optimal tax rules.